Audit Chapter 4 Notes

Losses

-Damages to the plaintiff -Depend on the nature of the engagement

The plaintiff security purchaser must prove lack of due diligence by the CPA.

Does not apply to Section 11 or Section 10(b)

The plaintiff security purchaser must prove reliance on the document.

Only applies to Section 10(b) of the Securities Exchange Act.

The Securities Act of 1933 applies to the above-described public offering of securities.

True

When damage to another is directly attributable to a wrongdoer's act, __________ is said to exist.

proximate cause

A document including audited financial statements that must be filed with the SEC by any company intending to sell its securities to the public through the mails or interstate commerce is called a __________.

registration statement

Breach of duty

-Auditor did not perform obligations listed in the engagement letter or performance did not meet professional standards -Does not imply auditors were negligent whenever misstatements due to errors or fraud are later found

Review of financial statements

-Consists of limited verification procedures, substantially less in scope than an audit -Provides limited assurance as to statements' reliability

Common Law

-Developed through case decisions -Generally arising due to: --Breach of contract --Negligence --Fraud

SEC

-Has power to prohibit CPAs from reporting on SEC registrants' financial statements -Can take punitive action against public accounting firms -Auditors are forced to report illegal acts by clients to SEC if the client fails to report through form 8-K requirements

PCAOB sanctions

-Monetary damages -Suspension of firms and accountants from engagements for publicly traded companies -Referral of criminal cases to the Justice Department

Criminal statutes

-Most lawsuits allege violations of federal securities acts -Usually class action lawsuits by investors

Third parties

-Must establish that losses resulted from CPAs performance -CPA breached a duty of due professional care

Defenses

-Negligence not proximate cause of losses -Other causes for losses, e.g. contributory negligence by client

Litigation Perspective

-Some cases are obviously a result of less than adequate audit performance -In many cases, some of the many estimates made in the preparation of financial statements are, in hindsight, proven wrong -Other litigation may be pursued due to other factors such as the ability of the CPA firm to pay

Compilation of financial statements

-The preparation of financial statements based upon information provided to CPAs by client -Not intended to lend any assurance as to statements' reliability

United States v. Simon (Continental Vending) (1969)

A highly publicized case in which auditors were held criminally liable for gross negligence. Two audit partners and a manager were convicted of filing false statements with a government agency, mail fraud, and violating Section 32 (a) of the Securities Exchange Act of 1934. This case also was largely responsible for the development of required disclosure of related party transactions (originally issued as SAS No. 6, and now contained in FASB Statement No. 57).

The plaintiff security purchaser must prove a monetary loss occurred.

Applies to Section 11 of the 1933 Securities Act and Section 10(b) of the Securities Exchange Act

The __________ case, a landmark case of liability under the Securities Act of 1933, involved criticism of the auditors' review for subsequent events.

BarChris

Failure of one or both parties to a contract to perform in accordance with the contract's provisions.

Breach of contract

If the CPAs provided negligent tax advice to a public company, the client would bring suit under:

Common law

Under common law, the CPAs who were negligent may mitigate some damages to a client by proving:

Contributory negligence

Reves v. Ernst & Young (1993)

Court decided accountants cannot be held liable under RICO act unless they actually participated in the operation or management of the organization

The most significant result of the Continental Vending case was that it:

Created a more general awareness of the possibility of auditor criminal prosecution.

Which of the following cases reaffirmed the principles in the Ultramares case?

Credit Alliance Corp. v. Arthur Andersen & Co.

Duty

Defined by GAAS, the engagement letter, and legal considerations.

The plaintiff security purchaser must prove privity with the CPA.

Does not apply to Section 11 or Section 10(b)

Constructive fraud

Does not involve a misrepresentation with intent to deceive (gross negligence)

Ernst & Ernst v. Hochfelder (1977)

Established that the auditors could not be held liable under Rule 10b-5 of the Act for ordinary negligence. The U.S. Supreme Court concluded that the auditors' knowledge of the fraud must be proved before damages can be recovered under this provision of the Securities Exchange Act of 1934.

Which of the following elements is most frequently necessary to hold a CPA liable to a client?

Failed to exercise due care

Breach of Contract

Failure of one or both parties to a contract to perform in accordance with the contract's provisions.

An insider who had knowledge of all the facts regarding the loans to the two paper corporations could nevertheless recover from the accounting firm.

False

The Securities and Exchange Commission would defend any action brought against the accountants in that the SEC examined and approved the registration statement.

False

If a CPA performs an audit recklessly, the CPA will be liable to third parties who were unknown and not foreseeable to the CPA for:

Gross negligence

Securities Exchange Act of 1934

Imposes liability on CPAs for their work on the financial statements included with a company's ongoing reports to the SEC.

Gross negligence

Lack of even slight care, indicative of a reckless disregard for one's professional responsibilities.

Loss sustained by a bank known to the auditors to be relying on the financial statements for a loan; suit brought in a state court that adheres to the Credit Alliance v. Arthur Andersen precedent.

Liable

Loss sustained by a bank named as a third-party beneficiary in the engagement letter; suit brought under common law.

Liable

Loss sustained by client; suit brought under common law.

Liable

PCAOB

May conduct investigations and disciplinary proceedings on registered CPA firm and professional employee

Fraud

Misrepresentation by a person of a material fact, known by that person to be untrue or made with reckless indifference as to whether the fact is true, with the intention of deceiving the other party and with the result that the other party is injured.

Violation of a legal duty to exercise a degree of care that an ordinarily prudent person would exercise under similar circumstances.

Negligence

Loss sustained by trade creditor, not in privity of contract; suit brought in a state court that adheres to the Ultramares v. Touche Co. precedent.

Not liable

Losses sustained by stockholders; suit brought under Sections 18(a) and 10(b) of the Securities Exchange Act of 1934.

Not liable

Private Securities Litigation Reform Act of 1995

Placed limits on amount of auditors' liability by establishing proportionate liability

Scope of CPA Liability

Potential liability may exceed that of other professions (such as physicians) because: -number of parties potentially suffering significant losses -possibly millions of investors as well as the firm's creditors -amounts can be excessive in some cases exceeding the limits of professional liability insurance

A method of allocating damages to each group that is liable according to that group's pro-rata share of any damages recovered by the plaintiff. For example, if the plaintiff was awarded a total of $500 thousand and the CPAs were found to bear 30 percent of the responsibility for the damages, the CPAs would be assessed $150 thousand.

Proportionate liability

Under the Securities and Exchange Act of 1934, auditors and other defendants are generally faced with:

Proportionate liability.

Damage to another is directly attributable to a wrongdoer's act. This issue may be raised as a defense in litigation—that is, the defense may argue that some other factor caused the loss.

Proximate cause

Written law created by state or federal legislative bodies.

Statutory law

In cases of breach of contract, plaintiffs generally have to prove all of the following, except:

The CPAs made a false statement.

Which of the following approaches to auditors' liability is least desirable from the CPA's perspective?

The Rosenblum approach

Ultramares approach (known user approach)

The auditors knew that the audited financial statements were for use for a particular purpose by a known user (third party beneficiary)

Restatement approach (foreseen user approach)

The auditors knew the audited financial statements were for use for a particular purpose, but the auditors did not necessarily know the specific user.

Rosenblum approach (foreseeable user approach)

The auditors should have realized that it was reasonably foreseeable that the financial statements would be used by this user.

A CPA issued an unqualified opinion on the financial statements of a company that sold common stock in a public offering subject to the Securities Act of 1933. Based on a misstatement in the financial statements, the CPA is being sued by an investor who purchased shares of this public offering. Which of the following represents a viable defense?

The false statement is immaterial in the overall context of the financial statements.

Escott v. BarChris Construction Corp. (1968)

The first significant case brought under the Securities Act of 1933. The auditors were unable to establish their due diligence, especially with respect to the S-1 review for subsequent events up to the effective date of the registration statement.

The 1136 Tenants' case was important because of its emphasis upon the legal liability of the CPA when associated with:

Unaudited financial statements.

Which statement best expresses the factors that purchasers of securities registered under the Securities Act of 1933 need to prove to recover losses from the auditors?

The purchasers of securities must prove that the financial statements were misleading; then, the burden of proof is shifted to the auditors to show that the audit was performed with "due diligence."

In court, investors who bought shares in Dandy Container need only show that they sustained a loss and that failure to explain the nature of the loans in question constituted a false statement or misleading omission in the financial statements.

True

The accountants could avoid liability if they could show they were not negligent.

True

The accountants could avoid or reduce the damages asserted against them if they could establish that the drop in the stock's market price was due in whole or in part to other causes.

True

The accounting firm has potential liability to any person who acquired the stock.

True

Ordinary negligence

Violation of legal duty to exercise a degree of care that an ordinary prudent person (CPA) would exercise under similar circumstances

An __________ is the written contract summarizing the relationship between the auditors and the client.

engagement letter

When CPAs are associated with __________, a possibility exists that the client may misinterpret the extent of the CPAs' services and believe that the accountants are acting as auditors.

unaudited financial statements

Joint and Several Liability

A legal concept that holds a class of defendants jointly responsible for losses attributed to the class as well as liable for any share of losses that cannot be collected from those unable to pay their share.

Proportionate Liability

A method of allocating damages to each group that is liable according to that group's pro rata share of any damages recovered by the plaintiff.

The plaintiff security purchaser must prove material misstatements were included in a filed document.

Applies to Section 11 of the 1933 Securities Act and Section 10(b) of the Securities Exchange Act

Securities Act of 1933

Applies to initial stock offerings, imposes liability on CPAs for their audit work relating to financial statements used to register the securities for sale.

United States v. Arthur Andersen (2002)

Arthur Andersen was accused of the wholesale destruction of documents relating to the Enron Corporation collapse. The jury found, based primarily on an email message that an Arthur Andersen attorney advised a partner to revise a memo to omit certain information, including a comment that an Enron press release that included an earnings announcement was misleading. Loss of this case effectively put Arthur Andersen out of business. The conviction was later overturned by the U.S. Supreme Court.

Statutory Liability

Develops when governmental unit passes laws and regulations imposing liability on CPAs

Losses to stockholders purchasing shares at a public offering; suit brought under the Securities Act of 1933.

Liable

Loss sustained by a lender not in privity of contract; suit brought in a state court that adheres to the Rosenblum v. Adler precedent.

Liable

The plaintiff security purchaser must prove the CPA had scienter.

Only applies to Section 10(b) of the Securities Exchange Act.

RICO Act

Racketeer Influenced and Corrupt Organizations Act, enacted in 1970 by Congress as a weapon against mobsters and racketeers who were influencing legitimate business. -"Racketeering activities" include mail fraud and fraud in the sale of securities. -Used against CPAs who knew or should have known of material misstatements of financial statements -Allows triple damages in civil cases